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U.S. Metals supplied custom-made stainless steel flanges for use in constructing nonroad diesel units at ExxonMobil refineries. During post-installation testing, ExxonMobil determined the flanges were defective and had to be replaced to avoid fire or explosion. Replacement was a complicated, destructive process that delayed operation of the diesel units for several weeks. U.S. Metals settled with ExxonMobil on the amount of damages caused by the defective parts, and sought indemnity from Liberty under its CGL policy.

Liberty denied coverage on the grounds that ExxonMobil’s diesel units were not damaged by installation of the defective flanges, or the loss fell under the “impaired product” exclusion (i.e., the property was rendered less useful by incorporation of the insured’s product but “can be restored to use” by removing the insured’s product).

U.S. Metals sued Liberty in federal court. The district court granted summary judgment for Liberty, and U.S. Metals appealed. The Fifth Circuit concluded the dispositive issues had not been resolved by Texas courts, and certified four questions to the Texas Supreme Court. Accepting the certification, the Supreme Court explained the “existence and extent of coverage … depends on whether ExxonMobil’s property was (1) physically injured or (2) restored to use by replacing the flanges.”

The Court noted the first issue was one “over which American jurisdictions have differed,” and on which it had not spoken. Adopting the majority position, the Court held that “physical injury requires tangible, manifest harm and does not result merely upon the installation of a defective component in a product or system.” Applying this principle, the Court concluded that, although installing the defective flanges may have “injured . . . the diesel units by increasing the risk of danger from their operation and thus reducing their value,” the harm was not “tangible” and therefore was not “physical injury.”

Reaching the “impaired property” exclusion, the Court acknowledged the diesel units were physically injured in the process of replacing the faulty flanges. This damage was excluded, however, because the units were ultimately “restored to use” by replacing the flanges. Accordingly, the only damages covered by the policy were the relatively minor costs of insulation and gaskets destroyed in the replacement process.

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